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Sunday, February 15, 2015

On the eve of the probably decisive meeting on whether Greece remains in the Eurozone (Grexit) some reflections seem in order on the nature of international debt negotiations. As always, some elements of complex dynamics and game theory prove useful, but most of all a study of historical analogies to the few similar historical moments of asymmetrical creditor-debtor brinkmanship again come to our aid (who says history is bunk?). The new Greek finance minister Yanis Varoufakis himself appealed to analogies with the plight of debtor Weimar Germany in the 1930s after his fruitless consultation with his German counterpart Wolfgang Schäuble, now in the enviable creditor’s seat. But I’d like to go even further back in time to the origins of the interwar debt and social crisis, the even more mistrustful negotiations in 1919 between the victorious Western allies and the new Weimar German government that had the sorry task of kitting together the shards of their country left behind by their Imperial German predecessors. We are lucky to have the testimony of an eminently astute first-hand participant/witness of these negotiations, no less than John Maynard Keynes.

The European Union was supposed to put an end to Europe’s twentieth century twin ills: territorial expansion and dysfunctional economic nationalism. They were to be replaced with an international system of the rule of law and mutually beneficial cooperation, eventually ending in some form of political and economic integration superseding the traditional boundaries of national sovereignty.

Instead we now find ourselves in a situation of deja-vu, with Russian revanchism now militarily and propagandistically dismembering the national sovereignty of a Ukraine whose national sovereignty Russia apparently never really accepted (despite the 1994 Budapest Memorandum), much like Nazi Germany’s attitude to interwar Czechoslovakia, while exploiting the disunity and weakness of the Western liberal democracies in a rerun of appeasement. And creditor and debtor nations, in the wake of a world economic crisis, are locked in an antagonistic cul-de-sac that has envisioned no other recourse than self-defeating debt-deflation resulting from austerity and the Euro/Gold Standard, much like the 1930s. All of this has been the subject of many blogs on this site over the years, and all of it seems to come to a head again every time I go to Goa on a working holiday.

With the election of the Syriza government in Greece the Eurozone, slumbering in an illusion of stability due to the willingness of the ECB to finally act as a lender-of-last-resort and implicitly mutualize Eurozone sovereign debt risk, and the stoical willingness of other peripheral countries to endure austerity and one-sided internal devaluation, has come to a critical juncture. A democratic electorate has signaled the end of its willingness to make sacrifices to the creditor countries and their banks that show little or no sign of restoring full employment and essential public services and have, predictably, made their debt load even less sustainable. Greece has always been the weakest link in the fragile structure of the Eurozone risk network, but the populist backlash has been brewing for some time in France, Italy and Spain as well. If the EZ finance ministers think they can face down Greece’s newfound obstreperousness, how will they act when they confront a Marine Le Pen as French president a few years hence?

German Finance Minister Wolfgang Schäuble (left) disagreeing to disagree with his gadfly Greek counterpart Finance Minister Yanis Varoufakis (right) Feb. 6 in Berlin. The gulf in sartorial styles is an indicative but imperfect proxy for the gulf separating creditor and debtor philosophies.

The only concession to Greece from the “troika” until now has been IMF Managing Director Christine Lagarde sporting a black leather jacket, demonstrating that at least some creditor representatives can beat Varoufakis at his own sartorial game. This strategic ploy evidently only provoked disgust from Eurogroup Finance Minister President Jeroen Dijsselbloem (far left) at the inconclusive meeting last Wednesday that did not even disagree to disagree. Dijsselbloem and Schäuble shared the Creditanstalt Mellon Memorial Prize in 2013 for the Expeditious Resolution of Banks. (Picture credit EPA)

The essence of the conflict between the new Greek government and the troika is not so much debt forgiveness or restructuring as the freedom to reduce the envisioned primary surplus from 4.5% to something like 1.5% and postpone impending repayments to the IMF and ECB. Already Greece’s debt service is only 1.5% of GDP due to extensions and lenient terms. What Greece suffers from is the miscalculation of its creditors in 2010 about the devastating effect of the imposed budget cuts and tax hikes (on the order of 20%) on the real economy and the social fabric: 25% unemployment (50% youth), termination of health insurance coverage, fire-sale privatizations… And the failure of exports to make up for the slack due to reduced public spending. Paul Krugman’s recent blog on Greece’s multiplier woes reiterates this point.

IMF projections of Greek unemployment from program implementation in 2010 (“SBA”) down to the 2013 program evaluation (“Latest”) show the extent to which the fiscal multiplier has been underestimated. (Source: IMF Country Report No. 13/156, June 2013)

The new Greek government’s bargaining position is weak. The ECB has placed limitations on its ability to issue short-term T-bonds. The final bailout tranche on Feb. 28 will not be paid without an agreement, threatening it with insolvency. Its banking system has been denied ECB rediscounting and will have to rely on Greek National Bank emergency liquidity funding, while deposits are evaporating in an incipient bank run. Time is not on its side.

Varoufakis’s idea of strategy is to hold a gun to his own head, then demand a ransom for not pulling the trigger.

German and European Union policymakers are calling his bluff. As a result, the two sides have become stuck in a passive-aggressive standoff that has made serious negotiation impossible.

However, the bluff they are calling is the unraveling of the whole Eurozone should Greece exit (or be de facto expelled). While German officials have been privately mooting that firewalls are now in place, in contrast to the situation in 2010, to prevent contagion to the next weaker Eurozone members such as Portugal, who really wants to play with this potential Lehman-like fire? Thus the two parties are really locked in a game of chicken in which whoever can project the greater appearance of irrational commitment wins (paradoxically, this is where rational choice theory takes us). And Germany has an incentive to make an example of Greece to deter any other country from similarly attempting to renege on its bailout terms, even if the punishment would be punitive for everyone and Greece claims to be a unique case. Ferdinando Giugliano in the Financial Times argues that such a Carthaginian/Melian solution may be in the offing (making an analogy with the war between Athens and Melos during the Peloponnesian War):

The problem with this strategy, however, is that the other player may choose to build a reputation for toughness. This is what Athens opted for — it laid siege to the island and starved the inhabitants into submission.

However one analyzes this confrontation, it is clear that a European project that was intended to promote cooperation and mutual prosperity has degenerated into a negative sum game of brinkmanship resembling war and reparations more than peace and co-prosperity. The tragedy of the current Greek government is, as Kaletsky puts it, that

Whatever form the surrender takes, Greece will not be the only loser. Proponents of democracy and economic expansion have missed their best chance to outmaneuver Germany and end the self-destructive austerity that Germany has imposed on Europe.

Financial Negotiations Anno 1919

French Finance Minister Louis-Lucien Klotz (left) and his Premier Georges Clemenceau (right) resisted proposals to allow the defeated Germans to use their gold reserves to purchase desperately needed food imports at the 1919 conference in Spa. The French were counting on these reserves as reparations. (Picture credits Wikicommons)

John Maynard Keynes was a member of the British Treasury delegation to the Supreme Economic Council of the Allied Powers in negotiations with defeated Germany and the subsequent peace negotiations in Paris that set the stage for the turbulent interwar years. His revulsion at the dysfunctional and draconian terms of the Treaty of Versailles led him to publish The Economic Consequences of the Peace in 1919 after resigning from the British delegation. The questions attendant on transferring such large sums between debtor and creditor countries without undermining the world economy continued to influence his thought down to his work on the Bretton Woods Agreement to establish a different foundation for the post-WWII era in 1944.

While The Economic Consequences of the Peace first propelled Keynes into the public’s eye, his experiences in these negotiations found a more intimate record in his essay on the economic advisor of the German delegation with whom he soon established friendly personal ties and shared economic viewpoints, Dr. Carl Melchior, in the 1949 volume Two Memoirs, based on a talk he gave in 1921 before the Bloomsburg Memoir Club. The predicament of the defeated Germans was that after four years of naval blockade they were on the verge of starvation but faced as yet undetermined reparation demands. The new Weimar government had hardly established its legitimacy and confronted putsches from the left and the right. Its army had dissolved, its bargaining power was minimal, and its expectation of being bailed out by American loans was, as Keynes pointed out to them, illusionary since this would require a Congressional vote. Keynes then recounts the scene at the negotiations in Belgian Spa in which French objections vociferously advanced by Finance Minister Louis-Lucien Klotz against allowing Germany to use its gold reserves to purchase food imports came to a dramatic and somewhat ludicrous head:

But Klotz was not yet beaten. He still withheld the gold. The Germans should be allowed to pay in any other way, but not in gold. He had shown, he declared, a very conciliatory spirit and had made great sacrifices, but it was impossible for him to go further without compromising his country’s interests, which (puffing himself out and attempting an appearance of dignity) had been placed in his charge.

Never have I seen the equal of the onslaught with which that poor man was overwhelmed. Do you know Klotz by sight?—a short, plump, heavy-moustached Jew, well groomed, well kept, but with an unsteady, roving eye, and his shoulders a little bent in an instinctive deprecation. Lloyd George had always hated him and despised him; and now saw in a twinkling that he could kill him. Women and children were starving, he cried, and here was M. Klotz prating and prating of his ‘goold’. He lent forward and with a gesture of his hands indicated to everyone the image of a hideous Jew clutching a money bag. His eyes flashed and the words came out with a contempt so violent that he seemed almost to be spitting at him. The anti-Semitism, not far below the surface in such an assemblage as that one, was up in the heart of everyone. Everyone looked at Klotz with a momentary contempt and hatred; the poor man was bent over his seat visibly cowering. We hardly knew what Lloyd George was saying, but the words ‘goold’ and Klotz were repeated, and each time with exaggerated contempt. Then turning, he called on Clemenceau to put a stop to these obstructive tactics, otherwise, he cried, M. Klotz would rank with Lenin and Trotsky among those who had spread Bolshevism in Europe. The Prime Minister ceased. All round the room you could see each one grinning and whispering to his neighbour ‘Klotzky’.

Clemenceau did what he could to save the face of his minister, blustering for a few minutes how his country had been ruined and ravaged; what guarantees had France in return for this?—merely a few pieces of gold, a few securities, which it was now proposed to take from them. In a word, he was being asked to betray his country, and that he refused to do.

But it was really all over, Colonel House had supported the Prime Minister. So now did the Italians, The six Japs had sat, and still sat, silent, rigid and seemingly unapprehending, attendants at the drama of another planet. It was tea-time. Loucheur and I were told to go into the next room to prepare a formula, The gold was to be used after all.

Klotz later denounced Keynes for vetoing a wartime loan to France to support the franc in a 1924 book, leading to an exchange of newspaper volleys culminating in Klotz’s characterization of Keynes’s

swollen vanity…hypertrophy of self which is akin to megalomania…It is Mr Keynes whom I accused and whom I continue to accuse. I said, and I repeat…that Mr Keynes committed towards France an acte atroce on 19 February 1919, when he assured the triumph of his monetary megalomania, which remains the true cause of the financial catastrophe which has fallen on the whole world.

Keynes for his part had been working since 1916 on a plan to cancel all inter-Allied debt “as being likely to promote the well-being of this country [GB] and the world.” Maintaining and aggravating the debt pyramid created by the war constituted a threat to the survival of capitalism (Dostaler, 143). Will the same be ultimately said of the debt pyramid created by the introduction of the Euro?

Lessons for Greece Today?

What are some lessons for contemporary Greece in its negotiations with the troika one can derive from the 1919 deliberations in Spa that would improve on its present losing strategy?

Play the starvation card. It’s hard to deny international lending when women and children are starving in the streets (redundant cleaning women on 80% pay may not be enough).

Slander you counterpart finance minister as a craven Jew obsessed with ‘goold’ (‘pound of flesh’). Better yet, get one of his allies to do it for you. This may be less effective today than in 1919, especially if he is a German Protestant in a wheelchair, but it may still be worth a try.

Claim that denial of funding and stringent terms will open the gates to political extremism (Bolshevism and Freikorps then, neo-Nazis and populist xenophobes now).

Point out that a Greece forced out of the Eurozone would be forced to seek funding from and align itself with Putin’s Russia. But this may be of greater concern to the US than the EU.

Clemenceau had been dissatisfied with his choice of Klotz as finance minister, reportedly complaining that he had placed in the Rue du Rivoli "the only Jew in Europe who understood nothing about money.” Klotz for his part never gave up trying to make Germany pay, down to his death in 1930 after falling into disgrace for passing bad checks.

Will German chancellor Merkel later lament that her finance minister Wolfgang Schäuble was the only schwäbische Hausfrau in Europe who understood nothing about international macroeconomics? Whose repeated insistence that “bailout agreements must always be honored” will go down in history with Klotz’s “goold?”

What will Chancellor Merkel be thinking when her finance minister Wolfgang Schäuble admits that he had no idea that his counterproductive austerity policies would lead to the breakup of the Eurozone and decades of stagnation and social unrest? (Picture credit DPA)

About Me

I'm a research economist at UNU-MERIT (Maastricht, The Netherlands) and IIASA (Laxenburg, Austria) with a specialization in the economics of innovation, complex dynamics, economic growth and evolutionary economics. By the 2008 world crisis at the latest it became clear that macroeconomics, financial markets and economic policy cannot be entrusted anymore to mainstream economists. Hence this blog.